Principal-Protected Notes: Hedge Funds For Everyday Investors

A principal-protected note (PPN) is a synthetic investment or structured product that creates a customized investment. PPNs have their own unique risk/return profile designed to appeal to specific groups of investors. They are created by financial engineers who combine derivatives with other derivatives (such as an index fund, mutual fund or commodity fund) or a traditional investment (such as a commodity, a stock or a bond). In this article, we'll provide an overview of this investment vehicle.

What Are PPNs?PPNs have become incredibly popular over the past few years. Their guarantee to return at least 100% of the original investment - provided the PPN is held to maturity - and a potential return exceeding that of a guaranteed investment contract (GIC) helps to explain their popularity. Demand for PPNs has also increased because unaccredited investors can access a hedge fund by purchasing a PPN. Hedge funds are a very popular investment these days, and they are not directly available to unaccredited investors due to security market regulations. (To find out more about hedge funds, see Introduction To Hedge Funds - Part One and Part Two.)

A principal-protected note is sold, or distributed, as a debt instrument with minimum return guaranteed to nominally equal the initial investment (the principal amount). Typically, a bank acts as the guarantor of the invested principal, which exposes the purchaser to a credit risk related to the guarantor. Therefore, it is extremely important to assess the guarantor's financial strength and creditworthiness. However, as most guarantors are financially sound banks, in most cases this risk is essentially nil. Although PPNs are sold as debt instrument, a PPN contains an embedded option and is really a derivative that has several features in common with traditional fixed-income products.

Like a debt instrument, the PPN has a face value, a term to maturity and a return of principal at maturity. A PPN's term to maturity - which depends on the combined investment products it contains, its structure and market conditions - usually ranges from six to 10 years.

Unlike a debt instrument, the return from a PPN depends on the terminal value of an embedded option; there is no guaranteed periodic coupon payment. Instead, a PPN usually makes one payoff, at maturity, consisting of the original principal and any increase in net asset value. The increase in the net asset value of a PPN is derived from the return of the underlying over the term of the PPN, as specified in the offering memorandum, taking various fees into account.

The Structure of PPN ReturnsA direct correlation between the payoff and the actual return on the underlying may or may not exist depending on how the note was structured and existent market conditions during the investment term. In other words, the payoff from the PPN is very likely path-dependent. With this in mind, a PPN can be viewed as a bond with a variable coupon payment ranging from 0% to some maximum as determined by its structure and described in its offering memorandum. In financial engineering terms, a PPN is a synthetic bond.

Although periodic payments are not the norm, financial engineers have created PPNs that do make periodic payments to appeal to investors who prefer to receive periodic returns. In most cases, the periodic payments are a return of principal and that each payment reduces the guaranteed principal by an equivalent amount. However, being creative, financial engineers have created PPNs that have periodic payments that may contain an earned return.

By purchasing a PPN, an investor acquires an embedded option linked to a risky underlying investment and its cash flows, forgoing a certain cash return. By investing in a PPN, an investor opts for an uncertain, but potentially larger, cash flow that may emanate from the option embedded in the PPN. However, a positive return is not guaranteed and should an investor only obtain back their original principal, they must realize that the foregone interest was the cost of insuring that their original principal would be returned. (To find out more, read The Importance of Time Value and Understanding The Time Value Of Money.)

The valuation methods used for standard asset classes are well defined because each member of a standard asset class has a set of common characteristics. It is these common characteristics that give them membership in the asset class. This is not the case for PPNs.

Each PPN constructed has a unique set of characteristics, which is partially determined by the underlying, how it is constructed and the market conditions that existed when it was issued (constructed) and during its lifetime (term), especially the interest rate environment. PPN disclosures are generally less transparent than those for investments sold by prospectus. This lack of transparency may be an issue when an investor attempts to determine the fees. Because risk is shifted when a PPN is constructed, a PPN and its underlying have different risk/return profiles. Because no two PPNs are alike, the valuation and comparison of two PPNs can be challenging. (To read more about interest rates, see How Interest Rates Affect The Stock Market, Trying To Predict Interest Rates and It's In Your Interest.)

Engineering a PPN, Ensuring the GuaranteeWhen a financial engineer wants to guarantee the nominal value of the original invested principal, a hedge will be involved. There are two common structures, which describe how the synthetic investment is created, and that are used to create a PPN. The main difference between the two is the hedging technique. In the zero-coupon bond structure, the simplest of which is a static hedge, the purchase of protection occurs when the PPN is created. The other structure, the constant proportion portfolio insurance (CPPI) structure, is more complex and uses a dynamic hedge to implement protection. With dynamic hedging, protection may be put in place and removed throughout the term of the PPN.

Zero-Coupon StructureThe zero-coupon structure, termed plain-vanilla by the financial engineering crowd, consists of a zero-coupon bond and a call option package on the underlying.

When the PPN is issued, about 70% of the principal is used to purchase a zero-coupon bond with a maturity matching that of the PPN, which matures to the value of the original principal. It is this purchase of a zero-coupon bond that protects, or hedges, the principal and, because it remains in place throughout the term of the PPN, it is a static hedge. The remaining funds (minus fees) are then used to make a leveraged investment in the underlying that have a notional value equal to the invested principal.

Interest rates prevailing at the time the PPN is created determine the cost of protection and, therefore, the funds available to purchase the call option package. As interest rates fall, the cost of protection will increase and funds available to purchase the call option will decrease. The opposite is true also, as interest rates rise, the cost of protection will decrease and funds available to purchase the call option will increase.

The performance of the PPN, although directly determined by the payoff on the call option package, is ultimately determined by the underlying's performance. The theoretical maximum increase in the value of a zero-coupon bond PPN structure would be the increase in the value of the underlying over the term of the investment. However, the actual return will be less, and is often capped at some percentage of the underlying's return. This is due to limitations of the structure imposed by market conditions. Because of these limitations and a requirement for the existence of suitable call options, the zero coupon structure is not as widely used as the constant proportion portfolio insurance structure (CPPI).

Constant Proportion Portfolio Insurance StructureThe CPPI structure is more flexible and more widely used. When a PPN is created this way, the initial step is an investment in the underlying equal to the principal invested less fees. The need for principal protection is determined by the performance of the underlying and, if principal protection is needed, a zero-coupon bond is purchased. Protection will be subsequently sold if it is no longer needed. Hedging, in this case, is dynamic because it is based on market events; therefore, the performance of the underlying must be constantly monitored and with the use of a complex formula, financial engineers determine whether protection is required.

If, during the term of the investment, the net asset value of the PPN equals the cost of protection, full protection must be purchased. This is the "knock-out scenario". If this occurs, the return of the original investment is the only possible outcome. If the knock-out scenario occurs early in the term of the PPN, an investor is left holding the bag, so to speak, with his or her funds locked in and purchasing power declining at the rate of inflation.

A CPPI structure may also entail the use of leverage, permitting a larger initial investment in the underlying. Usually, leverage is limited to two or three times the invested principal. This use of leverage exposes an investor to all the advantages and disadvantages of leverage. However, when an investor is invested in a PPN, the downside is limited and the potential to benefit from the use of leverage exists.

ConclusionA PPN is the purchase of risky investment combined with insurance, or downside protection. Relatively certain or less risky cash flows are exchanged for more uncertain, but potentially larger, cash flows. Realizing the return potential offered by a PPN requires favorable market conditions over its term. Unfavorable market conditions, which result in the return of the original principal, create, in real terms, a loss purchasing power due to inflation.